FOOL ON THE HILL
An Investment Opinion
The Wonderful World of Disney Warren Gump (TMF Gump)
October 12, 1999
If you've become a shareholder of Disney (NYSE: DIS) during the past couple of years, you may fear that I was in the loony ward when concocting the title for tonight's article. Since October 1997, Disney owners have endured a 9% loss in value while investors in the Standard & Poor's 500 index have enjoyed a 44% gain. If instead of looking at a two-year time horizon you measure performance from the stock's peak last May, you find that Disney shareholders have lost 36% of their value compared to a 22% gain for the S&P 500. Ouch. That's a nasty spell.
Despite having experienced poor business performance and horrible stock price performance in the recent past, I think it is way too early to consider the company a dinosaur headed toward decline. Of course, listening to the Wall Street "pros" might cause you to think otherwise. According to First Call, the current analyst consensus recommendation is a lowly 2.4, squarely in the middle of the hold range. When considering that number, though, remember that analysts recommendations usually only incorporate prospects over the next 3-12 months. While events over that time period can't be ignored, an investor who plans on being a shareholder for many years needs to be more concerned about prospects over a much longer horizon.
When you're buying Disney, you're acquiring a stake in much more than the company's namesake theme parks. You also are purchasing a sliver of the company that owns the ABC television and radio network, numerous cable channels including ESPN, the Disney channel, a 50% stake in Lifetime, and what will ultimately be a majority stake in Infoseek (Nasdaq: SEEK), when that company merges with Disney's Internet assets in the next few months.
You also pick up the rich library of animated classics associated with Walt Disney studios, as well as films distributed under the Miramax, Touchstone Pictures, and Hollywood Pictures labels. I could go on talking about the Anaheim Angels, Mighty Ducks, DisneyQuest, ESPNZone, and the Disney Vacation Club, but you get the picture by now. The company has a huge array of entertainment assets.
The company's performance has been surprisingly poor of late. For the thirty-nine weeks ending June 30th, the company posted revenue of $17.6 billion, up only 5%. Operating income, which represents the company's profits from core ongoing operations, fell 17% to $2.7 billion. Net income, which includes the impact of interest expense, corporate expense, and minority-owned assets, fell a more substantial 35%.
The main reason net income fell more than operating income is that the company recorded $246 million in losses related to its Infoseek ownership stake, which was acquired last November and not included in prior year comparisons. (About two-thirds of the Infoseek loss is goodwill amortization, an accounting charge that does not necessarily corollate to a true financial cost.)
Disney divides itself into three major business segments: creative content, broadcasting, and theme parks and resorts. Below are brief recaps of how each business performed through the nine months ending June 30th.
Creative content, which includes the movie studios, home video, retail stores, and character licensing, accounted for 42% of the company's revenue and 25% of operating profits during this period. It also suffered the worst results of the three groups, with sales off 1% and operating profit plunging 42%. The dismal results were caused by slower sales of video, weaker character licensing revenue, and lower sales at Disney stores.
The lone bright spot was theatrical movie releases, where films like Tarzan, A Bug's Life, and The Waterboy boosted results. This division will usually be Disney's most volatile performer, as so much of its sales are dependent on movie production and consumer trends. While recent performance for creative content is disheartening, the company has proven time and again its ability to find new ways to exploit its character stable to increase profits.
The broadcasting division, encompassing TV and radio operations, has also been suffering from poor results. Representing about a third of revenue and operating profit, this arm saw revenue increase a fairly slow 6% and operating profit fall 18%. The sales increase was driven by improved performance at ESPN, The Disney Channel, and the radio network. The reduction in profitability was caused by higher programming costs, particularly NFL games as the new contract takes effect. Many people are concerned about this division's future because of the decline of network TV. While it's true that the major networks have been losing market share for quite a while, it is important to remember that most of that loss is to cable channels. With its strong lineup in the cable arena, Disney is well positioned to participate in this shift.
Theme parks and resorts has been the stalwart performer in Disney's portfolio this year, reporting financials that closely correlate with what most have long expected from Disney as an overall corporation. The division's revenues rose 14% and operating profit increased 13%, helped by strong results from the Walt Disney World Resort and the launch of the Disney Cruise line last year. The company also picked up additional revenue from the acquisition of the 75% stake in the Anaheim Angels baseball team that it didn't own. The continuing excellent performance of the Disney theme parks is attributable to a great economy and drivers of additional traffic to the new Animal Kingdom complex.
While Disney's overall performance has been lackluster for the year or two, the most important question for any investor to ask is where the company will go. I won't hazard a guess as to exactly how Disney will transform itself and its operations, but the company seems extraordinarily capable of maintaining its preeminent position. Continued innovation and new product exploration are key ingredients to this success.
The company constantly modifies and adds new attractions and sections to its theme parks. While some of these ventures are not successful at launch (does anyone remember when EuroDisney was on the verge of bankruptcy?), it will aggressively restructure those operations until they are successful (EuroDisney is now quite successful). If it can't correct a problematic new venture, Disney will shut it down (it recently shuttered Club Disney due to a low return on capital).
Many people fear that Disney has lost out on the Internet wave because Infoseek and the Go network are not the dominant forces in the Internet space. While that is certainly true now, it is way too early to count them out over the longer term. With its broadcast and other entertainment operations, Disney has enormous marketing power that could prove integral to making its Internet operations successful. Being controlled by the owner of important radio, TV, and cable networks, it's hard for me to imagine how Disney's Internet operations will not ultimately be successful. Beyond just the raw marketing power inherent in such an organization, branding is likely to become increasingly important as more companies log onto the Internet. There aren't too many brands that can top the strength of Disney and ESPN, both of which are parts of Go.
I don't harbor any illusions that Disney is going to turn around all of its operations and start to post substantial earnings growth in the few quarters. In fact, I would say that is probably unlikely since it usually takes quite a bit of time to alter momentum for a ship as big as Disney. Nonetheless, I've learned as an investor that one of the best times to invest in large companies with a dominant franchise is when they are experiencing difficulties. While things may appear unstable for a while, the brand power and reenergized operations almost invariably result in a rebound. When that happens, the stock rapidly resumes its upward trajectory as everyone returns to an old favorite.
I have never been able to exactly time the recovery in these fallen brands, but acquiring stakes in bluechips like Nike (NYSE: NKE), Merck (NYSE: MRK), and IBM (NYSE: IBM) when they were struggling with short-term problems served me quite well in the past. I think it's about time to see if the strategy will work again with Disney.